Tax Risk

In the last audio, we talked about two of the four risks of retirement:  market risk or the risk of volatility of growing your funds and protecting your wealth and income risk: the risk of making sure that your income lasts as long as you do.

Now, we want to complete that story with two additional risks.  I would argue that these are the risks you are least attuned to and least prepared to address and that is tax risk which is how much money you get to keep versus how much goes to the IRS in the form of taxes and legislative risk which is the risk that Congress changes the rules and those changes negatively impact your life.

So let’s start with taxes.  Now in retirement, there are really three things that could happen to your taxes.  They could be lower than they are today or your taxes could be the same as they are today or your taxes could be higher than they are today.  Not too complicated, right?

The challenge is helping you understand which of these scenarios is likely to be true for you.  And with American savings, we often think about tax changes this way which is situational.  Situational tax changes are changes that happen between now and retirement based on you as an individual saver.  So that may mean how much income do I need in retirement and what tax bracket will that put you in?  It could also be, am I filing joint and married or am I single, divorced, widowed and filing at a single payer rate?  Situational taxes are how you are already considering your taxes in retirement if you’ve considered them at all.

This is why most people consider their taxes will be lower in retirement than they are today.  Because this is how we are trained to think with tax deferred savings.  The idea behind tax-deferred savings is that during your working years, you’re in a higher tax bracket and therefore you should defer your taxes.  Let’s not pay them at that high bracket.  Then in retirement, you would be at a much lower tax bracket and it makes sense to pay your taxes.  Now, if this equation holds true for you, then having all of your funds in tax deferred vehicles will provide a strong chance of success you may want in retirement to make the right choice.  But will this scenario actually unfold for you as planned?

Many savers believe in what can be termed, The Great American Savings Myth.  And that myth which is so imbedded in the way we utilize tax-deferred vehicles as Americans.  It’s this myth that our taxes are somehow going to be significantly lower in retirement than they are today.

Now why is this myth so pervasive?  Well, for the Greatest Generation, tax deferred savings did pay off.  Here’s why.  The Greatest Generation, my parents maybe your grandparents, what did they do?  They were children of the Depression.  They saved their tinfoil; they re-used their Ziplock bags.  They fought in World War II, they came home and when they went to retire, they tightened their lifestyle which means they traveled less, they ate out less.  In that way, they were able to reduce the amount of income they needed in retirement because they reduced the lifestyle that they lived in retirement.

You have to ask yourself though is that what do you want to do when you retire?  I would argue that for the baby boomers, gen Xers and all the generations that follow, this desire to live a lesser life in retirement is not going to hold true.  And that’s because for the Greatest Generation, retirement was where they went to wait out their end days.

But for today’s generations, retirement is the reward that we have earned for years of hard work and good faith.  And that means we want to live a full and robust lifestyle in retirement.  We want to travel.  We want to take our grandchildren on vacation.  We want to eat at new restaurants.  We want to have a good time with our friends and enjoy the reward of retirement.  Well, if you want to maintain your lifestyle in retirement, the chances are you’re going to want to maintain your general income levels as well.

And if you maintain your general income levels, the chances are you’re going to maintain your general tax brackets as well.  So this is where the myth of the tax savings that has been built on the IRA’s 401K’s and 403’s.  This is where that foundation starts to crumble a little bit.

Because the fact of the matter is you may not find yourselves in a lower tax bracket in retirement based on situational changes because you want to lead that lifestyle.  Which leads to the question, Why haven’t you considered it before?  And I think it’s this reason right here:  Most US advice around taxes and retirement, if it’s given at all, it is given through what I like to call a micro lens and a micro approach to taxes and retirement has, as its goal, to reduce taxes in a given year.

So if I’m trying to reduce taxes this year, a 401k or an IRA is an ideal savings vehicle because I get my tax write-off and deduction and I don’t have to worry.  I’ve lowered my taxes this year.

You don’t want to take a micro approach to taxes in retirement.

You want to take a macro approach.  And a macro approach to retirement taxes has as its goal not reducing taxes in a given year but reducing lifetime taxes in retirement.

Now this is hard to do because it’s easy to quantify the micro-savings from tax-deferred saving, right?  I can tell you what my write-off was last year for a tax deferred contribution on an IRA.

What’s challenging to do is to analyze the macro tax cost of these IRA’s and 401k’s.

So let’s look, for example, at how I would help you take a macro analysis of your current retirement approach versus a tax-free approach using an IUL.

So I have a sample client, John who is 45 years old.  I’m going to say he’s saving $10,000 annually in a 401(k).  He s going to save for 20 years until he retires at 65 and then he’s going to access that retirement income for 35 years until he anticipates his time will end at age 100.

And just based on these assumptions, let’s see his micro tax bill versus his macro tax bill.  As this client is saving in his 401(k), he is going to defer taxes.  He’s actually going to defer paying $50,000 in taxes which sounds like a great deal.  But he didn’t eliminate those taxes, he just pushed them off into the future.

And when he goes to access that retirement income in the future.  He’s paying taxes not just on his contributions, but also in all the funds that goes with it.  So his macro tax bill for this approach is actually $158K total in taxes that he’ll pay during retirement from age 65 to 100 from his account.

Now you can see why a micro view and a macro view often paint very different pictures.

This ultimately was not a good tax deal for John.

Now, what if he had saved in something tax-free instead – a Roth account or an IUL policy?  Well, now he’s going to have to pay taxes while saving.  So instead of deferring those $50,000 in taxes, he’s actually going to have to pay them.  That is his micro analysis.  Right?  Oh no, he had to pay $50,000 in taxes.

Now, let’s look at the macroanalysis.  Because what happens when he accesses those funds in retirement?  Suddenly, there is no tax bill due.  Instead of paying $158,000 as a macro-retirement tax bill, he got out the door only paying $50,000.

That’s a big savings of over $100,000 of lifetime taxes based upon when this sample client chose to pay his taxes.

So the reality for you on situational tax changes may be your taxes are likely going to be the same in retirement as they were were before you retired.  That’s because you don’t want to take a lifestyle cut in retirement.  We see that if your taxes stay the same.  Things don’t look so great from a macro perspective in an IRA or 401(k) or any other qualified tax vehicle.

There’s also a chance that your taxes could go higher in retirement than they are today and that chance comes from something called legislative risk.